Japan and US Busts

The study of market history is so valued by prudent contrarian investors because
we humans collectively never seem to learn from the great financial mistakes
of the past. While the unfortunate generation that actually makes these mistakes
learns really well, future generations soon forget these hard lessons and are
thus doomed to repeat history.

Market history never repeats itself exactly since each particular financial-market
situation is unique to one brief era that spawned it. Nevertheless, while not
identical various extraordinary situations throughout market history still
certainly tend to rhyme with each other. Especially the great booms, bubble,
bursts, and busts that rear their heads once every few generations or so in
a given nation.

These powerful cyclical phenomena are so similar in different episodes in
history precisely because they are driven by the same undying forces. The most
important of these are greed, fear, and herd instinct, innate traits woven
deeply into our human hearts that have never changed and will never change
regardless of advances in civilization, technology, and communication across
eras.

As long as we inherently emotional humans are involved in investment and speculation,
great manias and their devastating aftermaths will continue to slam into the
financial markets once every 60-year-or-so Kondratieff economic cycle. And
since we find ourselves in one of these peculiar events right now, our best
hope as investors to weather this brutal storm is to strive to understand the
past so we can gain a good idea of what we ought to expect in the rest of our
own post-mania era.

While we would typically have to dig back three generations in dusty tomes
to vicariously witness the post-bubble bust aftermath through the eyes of those
who actually lived through it long ago, today investors are blessed to have
an honest-to-goodness ongoing bust in Japan to which we can look for insights.

The Japanese experience offers an enormous feast of food for thought for American
investors today, as the Japanese stock markets are about a decade farther into
the bust process than we are so far in the States. In some ways, looking at
Japan today is like peering into an extra-dimensional window into the immediate
economic future of America.

One extremely important question in particular being zealously pondered by
American investors today has many looking to Japan for answers. It involves
the prospect of a mighty decade-long trading range in the States, similar to
what Japan witnessed after the first few two-and-a-half years or so
of its plummeting stock prices following the burst of its notorious Nikkei
225 bubble in late 1989.

This potential US-trading-range question is so important because the necessary
strategies for successfully investing in a bull market, bear market, and sideways
market are quite different. If the US markets are really destined to meander
sideways for many years like Japans, then neither purely bullish nor purely
bearish capital-management strategies will always fare particularly well.

The best way to understand the origins of this trading-range question is to
observe the post-bust-trading-range action from Japan in comparison with the
US stock markets. The range of similarities between the major US markets, particularly
the flagship S&P 500 and speculative-mania-ground-zero NASDAQ, and Japan's
elite Nikkei 225 stock index is quite striking. History is definitely rhyming
in these two busts, no doubt about it!

Our graphs this week attempt to accomplish this mission by rendering these
unique trans-Pacific markets in similar percentage terms for accurate comparison.
Since the Nikkei 225, S&P 500, and NASDAQ are all currently measured at
such vastly different index levels, we converted each index into an identically
indexed scale between 0 and 100. 100 represents the respective bubble tops
on each index while 0 is, well, zero!

All of the data graphed below is weekly from each respective index,
so the horizontal scales are denominated in weeks. Week Zero is the bubble
top for each index, while negative weeks count down to the bubble top before
it transpired and positive weeks count up from the bubble top after it collapsed.
Each vertical gray line on the first two graphs below corresponds to 52 weeks,
one year, so it is best to think of the graph squares in terms of years.

By rendering the Nikkei 225, S&P 500, and NASDAQ in comparable percentage
and time terms, easy visual comparisons can be made to help us compare and
contrast the similar yet still unique boom, bubble, burst, and bust experiences
of each of these three elite stock indices. This exercise also illuminates
the all-important decade-long trading-range question in the States.

The grand strategic picture is shown in our first graph, which encompasses
the entire modern history of the Nikkei 225 and superimposes the S&P 500
and NASDAQ experiences on top of it. After you spend a minute or two drinking
in this chart, you will totally understand why the Nikkei 225 experience is
leading so many investors today to believe that the US markets are in for a long sideways
trading range.

When you consider the vast cultural and financial differences between Japan
and the United States, the similarity in these boom-bubble-burst-bust profiles
from each country is absolutely remarkable. While the patterns carved by these
mighty market events in both countries are not identical, they've certainly
rhymed amazingly well.

On their initial boom ascent phases, both the Nikkei 225 and S&P 500 managed
to carve almost mirror-image upslopes. From 260 weeks before their respective
bubble tops to their very bubble apexes at week 0, the Nikkei and S&P lines
are essentially interchangeable. If we were to create some graphs without any
labels or numbers for reference, I bet that not even a tiny fraction of serious
students of market history could identify which ascent phase belonged to the
Nikkei and which to the S&P.

Once its all-time high was reached, the S&P 500 stopped tracking the earlier
progress of the Nikkei 225 and desperately tried yet failed to attain a new
high almost a half year after its March 2000 bubble top. This long American
topping process effectively decoupled the Nikkei and S&P connection and
ended the intimate interplay of their respective price lines. Today the S&P
500 still shows similar patterns as the Nikkei 225, but at a much higher absolute
index level than what was witnessed in Japan.

Interestingly however, beginning at these bubble tops the maniacal NASDAQ
started to track the Nikkei bubble burst exceptionally well. Both indices fell
by more than 45% from their all-time highs in a matter of only 40 weeks or
so!

A horrific 45%+ loss from an all-time-high in a major index in only 40 weeks
is a frightening event to witness that usually only happens off of major supercycle
bubble bursts. Thankfully today's American investors are unlikely to ever witness
anything like this again, since these types of bubble events are exceedingly
rare and generally only spawn once every three generations or so.

Since about the first year after their respective bubble tops, these three
great busts have followed similar downward trajectories but at very different
absolute indexed levels. The NASDAQ plummeted hard and fast as the tech stocks
were the most ludicrously overvalued of the entire US mania, speculative ground
zero. The S&P 500 had many more blue-chip companies that were expensive,
but at least they could still earn some profits for their shareholders so its
descent has been much slower. The Nikkei 225, interestingly, has tracked almost
exactly in the middle of the S&P 500 and NASDAQ.

The origin of the long-trading-range idea for the US markets is crystal clear
on the chart above. The S&P 500 has tracked the Nikkei 225 rather well
so far in our own American boom-bubble-burst-bust. The Nikkei fell aggressively
for 135 weeks after its ultimate top and then suddenly entered an utterly massive
decade-long sideways trading range. As goes the Nikkei so goes the S&P?

Provocatively the mighty S&P 500's latest major interim low of last October
happened 131 weeks into its own bust, so per the Japanese model the timing
was about right for a major interim low to be carved. The S&P 500 bear-market
rally since then has also tracked the Nikkei's earlier example rather well,
as the zoomed-in charts below illuminate in more detail.

It is certainly easy to understand why the long-US-trading-range theories
are gaining ground in the States in light of the remarkable similarities between
the Nikkei 225 and S&P 500!

Interestingly the bulls seem to be the most excited about this trading-range
idea, since to them it means that the Great Bear market will quit mercilessly
rending their flesh from their bones. Yet, the long Japanese trading range
was anything but bullish. While it started about two-and-a-half years
after the Japanese bubble top, it lasted for almost a decade before breaking
down to horrific new lows. Rather than a tolerable three-year bear market,
the long Japanese trading range multiplied it into a thirteen-plus-year Monster
Bear!

While the initial bounce that heralded the Japanese trading range happened
around this time frame in Japan, its ultimate bear-market low wouldn't be witnessed
until at least a decade later. While a 60%+ loss over two-and-half years seemed
bad in the early 1990s in Japan, today's 80%+ loss over a dozen-plus years
after the top seems infinitely worse. Since we mortal humans only tend to be
blessed with four or five decades of good investing time during our short sojourns
on Earth, we absolutely cannot afford over a decade of losses.

Can you imagine the wailing and gnashing of teeth in the States, not to mention
the utter destruction of general enthusiasm for investing, if a decade from
now the S&P 500 trades down to less than 50% of even last October's "low" levels?
It would be financially ugly and psychologically devastating, an exceedingly
bearish thing!

So, while many bulls today like the prospect of a Japanese-style trading range
since it means to them that the brutal bear market is about over, they ought
to look twice at the Japanese experience. In many ways a grinding, excruciating
decade-plus-long Great Bear is ultimately far more destructive than a more
rapid one that only lasts a few years like the early
1930s experience in the States.

What's ultimately less painful, a violent kick in the teeth for a few years
or seemingly endless torture for a quarter of one's adult investing life? Personally
I'll take the kick any day over the torture!

So, while the prospects for a similar decade-long trading range in the States
like Japan's are very real, it is crucial for investors to realize that
the Japanese Great Bear experience was and still remains to this day an exceedingly
hostile environment for long-term capital growth and wealth creation. If some
perma-bull tries to convince you that a Japanese-style trading range is a happy
thing compared to a fast and wicked Great Bear bust, don't be so sure.

By zooming in we can gain a greater understanding of how the US bust is tracking
the Japanese bust today.

At this shorter-term scale the raw similarities at times between the Nikkei
225 and the S&P 500 or NASDAQ are downright uncanny! Some of the particular
ascent-stage bumps in the Nikkei and S&P are practically identical to the
week. The mirror-image signatures of the attempted double tops in the first
major bounces after the initial index crashes in both the Nikkei 225 and NASDAQ
are utterly amazing. History continues to rhyme, richly rewarding the prudent
contrarians who take the time to learn its countless lessons!

Of particular interest to me are the recent October 2002 interim lows in the
US markets, which so closely match the initial major bounce leading into the
long trading range in Japan. As I mentioned above this bounce happened on week
135 for the Nikkei, week 131 for the S&P, and week 133 for the NASDAQ.
This fascinating parallel is even more apparent if we zoom in one last time
to the bust stages witnessed in each nation's respective markets.

This final chart is divided into 26-week chunks on the X-axis, half-years.
The post-week-130 parallels between the three busting indices are really extraordinary
and have added a great deal of popular support for the long-US-trading-range
thesis.

In all three indices, an initial major interim low was carved soon after week
130 which then led to a sharp bear-market rally. This initial bear-market rally
soon faded like all bear-market rallies do, but it did not collapse
to fresh new interim lows. Instead a modestly higher interim low was achieved
and then a second bear-market rally hit and launched each index up to new interim
highs above the previous bear-rally tops.

These first interim highs achieved around week 173 or so defined the initial
upper end of the Japanese trading range, something to bear in mind as the June
highs in the States actually transpired almost exactly on this very week on
the Nikkei schedule.

Once again there is no doubt that the pure technical price-only comparisons
are amazing. In examining these charts it is really easy to understand why
so many technical analysts are placing so much faith in the Japanese trading-range
model holding true for America over the coming years.

The only pure technical objection that can be raised is the much higher level
for the S&P at this stage in the bust (65% of its all-time bubble top)
compared to the Nikkei 225 (54%) in April 1993. In absolute indexed terms,
the S&P is currently trading 22% higher than the Nikkei 225 was at this
stage in its own bust, quite a bit higher. This ought to trouble the trading-range
enthusiasts, yet I haven't heard anyone bring it up yet.

While the pure technical price comparisons are stunning, price alone
isn't everything. I realize this is heresy to technical analysts, but many
factors lead to the buying and selling that ultimately directly sets free-market
prices. Over the long-term valuation matters, as investors need to earn
a reasonable return in the few short decades of good investing that most can
expect in their lives. In addition, the constantly warring emotions of greed
and fear drive short-term activity and hence prices, so sentiment must also
be considered.

The key component to understanding booms, bubbles, bursts, and busts is valuation.
Stocks get overpriced in bubbles due to rampant popular mania greed and then
they get underpriced in the subsequent busts as valuations mean
revert and overshoot. This over-then-undervalued cycle is witnessed in all of
the booms and busts in stock-market history.

Undervaluations during busts inevitably follow overvaluations during bubbles
like winter follows summer. Like the seasons the Long
Valuation Waves are nonnegotiable, impossible to stop! General-market valuations
are measured by the classic valuation metrics
of general-stock price-to-earnings ratios and dividend yields.

Having spent years of my life studying stock-market valuations in booms and
busts, I believe that no boom and bust analysis is complete without considering
current valuation multiples. Today the S&P 500 is trading near 26x earnings,
still almost in official bubble territory at 28x! Meanwhile it is only
yielding 1.7% in dividends, abysmally low by all historical standards.

Meanwhile the hyper-overvalued NASDAQ remains a classical bubble to this
day at 38x earnings and yields nothing in dividends. These grossly excessive
valuations reveal that today's US index levels remain far, far too high based
on the actual collective underlying earnings power of the publicly-traded
corporations that comprise them.

Historical Great Bear bottoms only happen at general-market P/E ratios under 10x
earnings and general-market dividend yields over 6%. The general US
stock markets will get there too in this bust, either via continued
sharp falling or by an excruciating decade-long
grinding lower, just as happened in Japan. But with US stock valuations
still remaining this crazy, there is absolutely no question whether or not
the Great Bear is finished. It is not! It will return to maul investors
until general valuations are once again historically low.

So while the technical Japan/US comparisons are certainly provocative and
worthy of study, they are woefully incomplete when valuation is not considered
as well. While I always know exactly where the US markets are trading in valuation
terms, unfortunately my team and I have been unable to secure historical Japanese
valuation data. We have been looking for several years now for monthly P/E
and dividend yield data for the Nikkei 225, but no one seems to have it.

Until you and I can fully understand the kinds of valuations at which the
Nikkei 225 actually traded during various stages of its own bust, we really
can't make any comprehensive comparisons. As always, if we get a hold of this
data at Zeal I will not hesitate to write an essay on it to share the insights.
Needless to say, if you have this priceless Nikkei 225 valuation data I would
love to hear from you!

If the Nikkei 225 was as overvalued as 26x earnings at this stage in its own
bust like the S&P 500 today, then I suspect that we have a much higher
probability for a long US trading range dawning than if the Nikkei was already much
less overvalued by this time. For example, if the Nikkei was already
under 20x earnings when it entered its long trading range, that greatly reduces
the probability that the US can follow suit at its own far higher valuations
prevalent today.

Sans these crucial Nikkei valuation metrics however, pure technical comparisons
are quite shallow and not necessarily meaningful if trans-Pacific valuations
happen not to be comparable.

And there are also profound differences between Japan and the US, both culturally
and across the vastly different decades in which our respective busts played
out. Since I was just discussing the probability of an extended US trading
range in the August issue of our acclaimed Zeal
Intelligence monthly newsletter for our subscribers, here is a quote dealing
with a couple mega differences that simply must not be overlooked&

"Nevertheless, even though striking similarities exist, so do some amazingly
profound differences. For example, in the 1990s the Japanese were the greatest
nation of hardworking savers and exporters on Earth. The N225 trading range
existed while Japan was exporting countless hundreds of billions of dollars
of goods to the States as the US speculative manias in the 1990s fueled previously
unthinkable levels of consumption."

"If we Americans hadn't been around last decade, fat and happy and greedily
buying up everything in sight, would the Japanese bust experience have been
different? Unlike Japan in the 1990s, today the US is sadly the greatest nation
of debtors and importers on the planet. The US has relatively little heavy
industry left, its balance of trade is massively negative, and Americans are
leveraged to the hilt with the debt that financed all the gross excesses of
the 1990s."

"While the 1990s were a decade when supplies were tight and factories ran
24/7 around the globe to meet primarily US demand, the 2000s are an ugly decade
with a global bust. Even if the Americans did save and export, which we don't,
who is left in the world to buy American products and lift up the US economy
like the US economy did for the Japanese during their decade-long trading range?"

"Regardless of the pure technical price comparisons between the N225 and the
SPX, I believe that any such comparisons must fully consider the vast differences
between the US and Japan, and also between the different global economic environments
of the 1990s and the 2000s. Will the US really happily follow the Japanese
bust script?"

The rest of this current August issue of ZI goes on to discuss the prospects
of a decade-long trading range in the States and why the probabilities seem
to be conspiring against a similar decade in America. If you are interested
in reading this letter, we are offering a complimentary copy of it to all e-mail
PDF-edition new subscribers to Zeal Intelligence this month. Please
consider joining us today!

While the index comparisons between the Japan and US busts are indeed provocative,
many differences also exist which must be considered. In addition, in
the absence of Japanese valuation data such as monthly Nikkei 225 P/E ratios
and dividend yields, no true comparison can really be made. If we are blessed
to secure that data that we have sought for so long, I will write another
essay showcasing it and continue these fascinating Japan/US parallel-bust studies.

In the meantime though, please realize that while a massive long-term trading
range is certainly possible in the US, it isn't probable. In addition,
another decade of Great Bear grinding in America would do incalculable
financial and psychological damage, probably far worse than a sharp and vicious
plunge to a final low such as the early 1930s.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to
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